Hugo Thompson is multi asset product specialist at HSBC Global Asset Management
For the past several years most investors have faced a simple but abiding problem: asset markets have been climbing for close to a decade and now nothing looks cheap.
However, in 2018 things began to change. During the year, as the global economy looked like it was slowing, investors became increasingly nervous about the stock market, especially considering the eye-watering valuations wielded by many of the world’s largest companies.
Furthermore, after one of the longest bond bull runs in history, credit spreads – the amount businesses pay to borrow above the amount governments’ pay – started to look unsustainably tight.
Finally, as policy makers began to shut off the nitrous oxide that was quantitative easing, bonds markets looked increasingly unappealing.
Given the events of 2018 many investors have begun to wonder whether now is the time to solidify their gains, move their portfolios out of the markets, and store their savings in cash.
Prima facie, this is a sound investment thesis, it rests on the first law of commerce: buy low and sell high. If the market is offering an attractive price for your assets, then sell up and store your money in cash, you can buy back in once valuations look more reasonable.
A number of investment managers offer products which employ this principle as the primary investment device. Often referred to as market timing strategies, the investment thesis is simple: rotate client money out of markets which have reached their peak, and into markets which are due for a rally.
An example would be rotating between Chinese equities and cash:
1. Buy Chinese equities at the end of 2014
2. Sell before they fall at the end of Q2 15
3. Rebuy the market at its nadir in 2016
4. Hold it all the way to the next peak at the end of 2017
5. Then sell right before the 2018 emerging market turbulence
Past performance is not a guide to future performance
Following the above strategy would have resulted in investment growth of over 150 per cent in under 5 years. Market timing strategies are able to deliver exceptional returns, all you need to know is which direction the market is going to move next.
That said, anyone would make money if they knew how the market was going to move next. That is why these strategies often have impressive backtests, but struggle to deliver live track records with the same stellar returns.
All too frequently investors pull their money out of the market too early and miss a great deal of growth, or buy back in too late, having missed the vast majority of the appreciation.
The problem is that, in the short term, markets are volatile, unpredictable and frequently dislocated from fundamentals. This makes consistent, accurate prophecy of short term market movements very difficult.
Investing comes with risks; investments may fall in value and investors may not get back the original amount invested.
Have markets reached their peak? Asset markets have been climbing for close to a decade and now nothing looks cheap
Rather than attempt to time the market, we believe that the best way to create value is by constructing a diversified portfolio which maintains long term exposure to a wide array of lowly correlated asset classes. This smooths volatility while maintaining strong performance and attractive risk adjusted returns.
Research by AQR came to a similar conclusion: the most effective way for investors to weather drawdowns is through diversification, not market rotation.
The question remains, how to decide which assets are included in the portfolio, and in what proportion? We advocate using robust, academically recognised investment techniques.
The academic literature tells us that, in the long run, the returns of an asset are determined by a combination of the asset’s current valuation, the macro and style factors exposures of the asset, the present economic environment, and the tendency for mean reversion.
Using these inputs it is possible to model long term asset class returns and then construct an optimal portfolio considering asset class correlations.
Although the composition of a portfolio should be stable, it should not be static. As valuations fluctuate, asset class momentum changes or the external economic conditions evolve, the return characteristics of each asset class will change. These changes should be reflected in a portfolio’s long term asset allocation.
Shorter term, or ‘tactical’, positions can and should be used to add value. However, when short-term positions are initiated they should have a sound economic rational and not solely focus on following the crowd.
Market timing makes for a compelling investment narrative. It can certainly be useful as one input into tactical asset allocation decisions. But a sustainable driver of long term returns it is not.
Investors who want to move beyond myopia, neutralise the market noise, and generate sustainable returns should focus on creating globally diversified, long term, fundamentals driven, investment portfolios.